Lorenzo Bini Smaghi is a former member of the executive board of the European Central Bank and currently visiting scholar at Harvard’s Weatherhead Center for International Affairs and at the Istituto Affari Internazionali in Rome

All posts by Lorenzo Bini Smaghi

As the recent experience in the US and Japan has shown (and the FT’s James Mackintosh” explains), quantitative easing may produce its strongest effects on financial markets before the policy is implemented. In other words, it is the expectation that the central bank will embark on massive asset purchase that matters most, more than the purchase itself. And the more markets are convinced that the policy will be successful, the less the central bank may need to actually intervene.

When it comes to the eurozone, markets continue to have doubts about whether the European Central Bank will ultimately be willing to purchase government bonds. Indeed, such a policy decision seems to raise legal and institutional issues that make it “the instrument of last resort”. The ECB has clarified that the purchase of government bonds in the secondary market is not prohibited by its statutes, and can be used if the purchase of private assets is insufficient to boost the size of the balance sheet back to 2012 levels. Read more

In a recent article in the FT, Otmar Issing suggested that there are no good reasons for a country like Germany — which enjoys near-full employment and has a balanced budget, a debt “far above target” and an extremely loose monetary policy — to embark on an expansionary budget policy. He asks: “Where is the economic textbook that argues that such a country should run a deficit to stimulate the economy?” Read more

Most of the news which has come out since the European Central Bank’s last governing council, in early September, has made life more difficult for Mario Draghi.

On the economic front, eurozone inflation continues to fall, dangerously approaching the zero bound. Inflation expectations have plunged back below the trough recorded in the summer. Hard and soft indicators all point to a slowdown in economic activity, now affecting also the core of the monetary union.

Concerning the effectiveness of monetary policy, the results of the targeted longer-term refinancing operations (TLTRO) have been much lower than expected, and concentrated on the periphery, which may create new stigma and discourage further drawings in future. The size of the ECB’s balance sheet continues to shrink, while money and credit aggregates are still disappointing. Read more

The European Central Bank is the only major central bank in the advanced world that has not implemented quantitative easing – yet. A lot of arguments have been argued in defence of not following the Federal Resere, the Bank of England and Bank of Japan along the path of QE. But their validity is fast diminishing. Here is why QE’s detractors are wrong – possibly dangerously so. Read more

The latest data release of the Italian second quarter gross domestic product shows that the economy shrank 0.2 per cent, confirming that the country is back in recession. This is worrying in several ways. It brings GDP below the 2000 level, making Italy the worst performer since the start of the European monetary union. The slowdown in exports, the only component of GDP that had grown in the recent past, shows the underlying fragility of the country’s economy and its lack of competitiveness. The negative result, together with the very low level of inflation, makes debt sustainability more difficult to achieve, thus raising new concerns in financial markets.

The most worrying aspect, however, is that the recent number proves once again how wrong economic forecasts have been about the Italian economy. At the end of last year, the consensus of Italian and international institutions projected the 2014 GDP growth at about 0.6 per cent. The Italian government courageously aimed at 0.8 per cent. These forecasts were revised down earlier this year – and lately by the International Monetary Fund – to 0.3 per cent. The last release will probably induce a further correction towards zero. Read more

As the Federal Reserve starts tightening US monetary conditions, a key issue is how capital markets will respond overseas, especially in the eurozone. Given the relative size of the US financial system, the rise in short and long-term interest rates on dollar assets can be expected to translate directly elsewhere. Higher yields in the US will attract capital from other parts of the world, thus raising rates there too. The overall impact will nevertheless depend on the reaction of local policy authorities and on the portfolio preferences of global investors.

A year ago, when the Fed hinted at tapering, the reaction differed across regions. In several emerging markets rates started rising, reflecting a reassessment of the risk profile of several larger economies, such as Turkey, Brazil or Russia, leading to massive capital outflows towards safe havens. The eurozone, on the contrary, was not affected much, benefiting itself from capital inflows coming in from emerging markets. Global investors had reassessed their view of the eurozone economy, in light of the interest rate convergence between member countries produced by the European Central Bank’s “whatever it takes” announcement, but also of the concrete progress realised in the implementation of banking union and the prospects for a strengthening economic recovery. As the tail risks in the euro seemed to fade away, international investors did not want to be overweight in one currency only, and a large part of the outflow from emerging markets landed in the eurozone, strengthening the euro exchange rate. Read more

The Bundesbank is right to remind us that the unprecedented monetary accommodation in the eurozone has produced undesirable side effects. In particular, the policy has reduced the pressure on politicians to pursue speedy budgetary consolidation and to implement structural reforms. In the summer of 2011, for instance, as soon as the European Central Bank intervened to purchase Italian and Spanish government bonds through the Securities Market Programme and the spread on interest rates decreased, the commitments made earlier by those two governments began to be diluted. The same thing happened two years later, after the announcement of the Outright Monetary Transaction by the ECB contributed to sharply reduced market tensions, but also structural reforms.

It is not clear, however, whether or how central banks should incorporate these effects into their own policy frameworks. In other words, should central banks try to calibrate monetary policy – in particular, by being tighter than would otherwise be the case – with a view to keeping a tight leash on governments and inducing them to play their own part? There may be some good reasons for doing so but on balance it would be a serious mistake. Here are several reasons why. Read more

If European leaders want to fight the wave of eurosceptics which has risen with last week’s parliamentary elections, they have to address the two main criticisms of the EU: a lack of legitimacy and inadequate economic policies.

There are two ways to address the lack of legitimacy of European institutions. The first is to strengthen the national basis of representation. This would mean involving more directly the party leaders who won the largest support at the election – including Nigel Farage of the UK Independence party, Marine Le Pen of and Alexis Tsipras of Greece’s Syriza – to discuss Europe’s way forward. It is understandable that some heads of state do not want to follow this line. Read more

Monetary policy in the eurozone seems to be facing a conundrum. Each time the European Central Bank signals its intention to ease its policy stance, market sentiment improves markedly, which attracts capital flows to the euro area. This in turn leads to a rise in asset prices, including the exchange rate.

The reason is that the eurozone, in particular some of its member countries, badly needs lower interest rates to achieve debt sustainability. If nominal interest rates remain above nominal gross domestic product growth, a higher primary surplus would be required to stabilise and reduce the debt, which means more austerity and a renewed risk of vicious circle of low growth and higher debt. If instead interest rates fall further, the current fiscal plans become more sustainable, which is good news for investors. Read more

The surprising statement by Jens Weidmann, head of the Bundesbank, that quantitative easing “is not out of the question” in the eurozone, is not that surprising after all.

Last month’s judgment by the German constitutional court on the European Central Bank’s Outright Monetary Transaction indicated that the main problem with the commitment to do “whatever it takes” to save the eurozone lies in its unlimited nature, which could lead the central bank to purchase a large amount of assets of a specific country and thus take on to its balance sheet risks that could have budgetary consequences outside the control of national parliaments. The statement implicitly recognised that there would be no objections if the purchase of assets was limited rather than open-ended; and spread throughout the eurozone rather than concentrated on only one country. Read more

As on past occasions, the agreement reached by eurozone finance ministers on the single resolution mechanism will officially be saluted as a big step towards a fully-fledged banking union. But many will be disappointed because the agreement falls short of expectations.

The mechanism is unsatisfactory from several viewpoints. The decision-making process is cumbersome and involves too many bodies. The funds are insufficient to tackle a big banking problem. The ability of the mechanism to borrow in the markets is still unclear. The period of transition to the final system is too long, at least compared to the frequency of banking crises. Overall, the separation between banking and sovereign risk – which was the main goal of the union – has not been achieved. Read more

As economist Robert Triffin explained more than 50 years ago, the development of an international reserve currency requires that the issuing country or area records a current account deficit. This partly explains why the yen and the Deutschmark did not develop an equivalent role to the dollar, in spite of the relative strength of the Japanese and German economies. The eurozone economy is now in the same position.

The eurozone countries have adjusted, during the financial crisis, from running a broad external balance, which prevailed until 2010, to a rising surplus (2.7 per cent of gross domestic product in 2013, up to 3 per cent in 2015). Read more

Significant reforms are needed to fix the country’s problems. The coalition should take the opportunity of recent splits in several parties to force an agreement on a detailed series of measures that could turn around the economy, making it competitive again. Read more

The ECB’s recent announcement that it will start a comprehensive assessment of the eurozone banking system is good news. It will provide a uniform evaluation of 130 credit institutions, which should contribute to reducing the uncertainty about the overall health of the eurozone financial system and thus reduce its fragmentation. Read more

The main reason why the US Federal Reserve decided not to start tapering asset purchases at its last meeting was that the central bank considered the US economy to be still too fragile. The stock market nevertheless reacted with euphoria, jumping to new record levels.

The two facts are not easy to reconcile. The stock market rally should mean that investors are bullish about the earnings of the major listed companies, which should happen only if the US economy is on its way to a strong recovery, contrarily to the Fed’s forecast. If instead its view of the economy is correct, market prices are too high and are likely to be reversed downwards. In any case, asset prices do not seem to be in line with the central bank’s view of the US economy’s underlying fundamentals. Read more

Some central banks in advanced economies have recently put themselves into an uncomfortable corner. They have started to implement “forward guidance”, which consists of communicating to the markets their views about the appropriate level of interest rates, with the aim of influencing them. Unfortunately, the strategy is not working as expected. In spite of the central bank commitment to keep the level of policy rates unchanged, or even lower, for a prolonged period of time, market rates have risen instead.

The reason why forward guidance is not working is that it is not time consistent. If central banks really want to convince market participants that the prevailing rates over different maturities should be lower, they should explain why. In particular, they should provide arguments to dismiss the assessment made by market participants according to which interest rates are expected to rise over the medium term. In this respect, they could use at least two arguments. Read more

The European Central Bank is the only major monetary authority in the world that does not publish the detailed minutes of its proceedings nor the voting record of the members of its decision-making body. The discussions which have been recently started by some ECB governing council members have raised expectations that major changes will soon be introduced. These expectations may be disappointed. Read more

The eurozone financial crisis has lasted so long and been managed so poorly because policy makers have disregarded some fundamental aspects of the way in which financial markets work. In fact, the euro was created under the assumption – or rather the illusion – that financial crises would never happen because markets would discipline member states’ budgets. Furthermore, when the first problems emerged in Greece, the risk of contagion to other countries was ignored and the crisis was addressed in a piecemeal approach. Only when contagion became apparent and threatened the integrity of the eurozone was an agreement reached to create a safety net. Read more

Concerning independence, it seems peculiar that the Court called a national institution, the Deutsche Bundesbank, to testify. Since 1 January 1999, the Bundesbank has been an integral part of the Eurosystem – the chain of institutions headed by the ECB – for its monetary policy functions.

Like all the other national central banks of the euro area, it is not responsible for deciding the single monetary policy of the euro area, but only for implementing it. How can part of an institution express a different opinion from the rest, without undermining its integrity, and thus its independence? Read more

The transmission mechanism of the euro area monetary policy is not working properly, as interest rates charged by the banking system vary widely across countries. This hurts small businesses in particular, as they have to rely on bank credit much more than large companies which can issue debt in the capital market. As a result, countries which are implementing fiscal restriction cannot fully benefit from the monetary policy easing implemented by the ECB. Under these conditions the adjustment risks being self-defeating. Read more

An apparently obvious conclusion from last month’s Italian elections is that citizens – ie, voters – don’t like austerity programmes. The question that voters, especially in Italy, may not yet have reflected upon is what is the alternative in order to reduce the excessive burden of the debt, public or private, which has been accumulated over the past. There are at least three choices.

The first is to inflate away the debt, through the central bank buying large amounts of risky assets, thus socialising the losses, and keeping interest rates low, so as to reduce the real value of the debt. Some central banks around the world are indeed trying to pursue such an avenue, but the success is yet to be proven. In Europe this solution is prevented by the agreement that the member states reached at the launch of the euro that the European Central Bank should be independent and conduct monetary policy with the primary objective of pursuing price stability. Read more

The leaders of the largest economies have tried to talk down the risk of a currency war. This will not necessarily be sufficient to avoid one. The reason is that there is no longer a shared view across leading industrial countries about the role monetary policy should play in the current environment. Read more

The missing word in the election debate is competitiveness. Italy’s economy has lost competitiveness over the past decade or so. Internal labour costs have grown at a faster pace than productivity, and faster than in most of the rest of the world. Since the creation of the euro, Italy’s unit labour costs have risen by about 30 per cent more than the currency area average. Read more

Bank supervisory authorities that are not sufficiently independent, and are too closely associated with the political authorities, are generally under pressure to delay the identification of insolvent banks, for the fear that taxpayers would get upset. The problem thus tends to be postponed, and the cost to the taxpayer rises. The experience of the recent crisis has shown that taxpayers have paid most in countries where supervision was less independent and where the political authorities are most closely associated with the banking system. Read more

If a central bank gives the impression that it stands ready to be the “only game in town”, it will end up being played. The other policy makers will have no incentive to take on their own responsibilities. This will ultimately drag the central bank into monetising the debt and lose its reputation. Read more

Economic hardship pushes public opinion to become more inward looking and focused on domestic problems. As a result, solidarity among eurozone countries may weaken. In response strong co-ordination of the fiscal policies of the member states could lead to a reduction in imbalances within the euro area and stimulate overall demand Read more

Those who interpreted the IMF’s recent World Economic Outlook as evidence that austerity is self-defeating are mistaken. The fiscal multiplier, which has attracted so much debate, measures the one-off impact of changes in tax or spending on the economy when the adjustment is made. It does not measure the impact of changes in tax or spending on the long-term growth rate. There is little in the study to suggest there is an advantage in postponing adjustment. Read more

The expression of a dissenting opinion, especially when the opinion coincides with the view of a large part of the population of the respective country, generates the impression that discussions within the Governing Council are politicised, and that all members reflect national views. This may encourage pressures by national constituencies on the different ECB Council members to act on the basis of national interests, rather than the broader European ones. Read more

This assumption is currently far from being satisfied. The euro area financial market, in all segments and maturities – including the very short term money markets – does not function properly, as banks deposit their excess liquidity with the central bank instead of lending to other banks. Cross-border banking flows have dried up. Households and firms across the union borrow at rates which depend more on the respective sovereign risk — just look at Spain, today, for example — than on their intrinsic creditworthiness. Interest rate decisions made by the central bank are not able to affect monetary conditions in the desired way in a large part of the euro area. Read more

If Greece remained democratic, the government would most likely lose support from its own citizens for its request to leave the euro. It would then have to start negotiating with its partners on the terms for staying, rather than leaving, the euro from a much weaker position. Read more

The way in which the Bankia – and other – cases have been managed over the past few weeks confirms that banking supervision in the euro area cannot continue to be implemented in a decentralised way. The incentives of the national authorities to free ride are simply too high and undermine the stability of the entire euro financial system.

The traditional argument put forward in defense of conducting prudential supervision at the national level is that supervisory authorities have to be accountable to taxpayers, who ultimately bear the economic consequences of bank failures. As long as bank rescue operations are financed by taxes collected at the national level, so goes the argument, supervision should remain national. Read more

The eurozone economy is projected to be in recession this year and to barely stabilise in 2013. This should provide grounds for a depreciation of the Euro against other major currencies.

Yet such a depreciation is not happening. The reason is that several foreign official institutions, notably the central banks of emerging markets such as China, are continuing to intervene in the foreign exchange market to buy Euro-denominated assets at a pace which more than compensates the sales of private market participants. Read more

Policy makers act when they feel the pressure of the markets – but as market pressure abates, they start thinking that the worst of the crisis is over. Decisions are postponed, measures are watered down. As the political process stalls, markets start having doubts about policy makers’ determination and lose confidence again, which gives rise to new turbulence. Such a system, in which policy makers act mainly under market pressure, while thinking that markets are myopic, is not only unstable; it is inefficient.
Trying to regain market confidence, having once lost it, requires much tougher actions, which cause economic pain and are unlikely to be the best way to consolidate domestic political support. Read more

The markets seem to have coped relatively well with “the biggest sovereign restructuring ever” last week. But they are already focusing on the next possible victim: Portugal’s bond yields have soared to levels close to those on Greek bonds a few months ago. European authorities have publicly declared that Greece was unique and that there will be no more debt restructuring. Undoubtedly, though, they will be tested in the coming months.

The best strategy is to immediately build a firewall that would ensure Greece is an exception. First, it should be recognised right away that Portugal may not be able to return to the markets next year and needs an additional bailout package. Second, the same could be done for Ireland, which requires an additional €80bn. The procedure to allocate these funds should be started right away by the national and European authorities. Third, the size of the EFSF and European Stability Mechanism must be further increased to allow them to provide additional funds to other countries.

Only by acting forcefully, in anticipation of what the markets will focus on next rather than under their pressure, can European authorities convince us that Greece was an exception and prove their commitment to do all that is needed to preserve the euro as a currency. Read more

With the €530bn lent to banks through its latest three-year longer-term refinancing operation, the size of the European Central Bank’s balance sheet has increased to unprecedented levels, raising a number of concerns. Not all are justified.

The main concern is that sooner or later the increase in central bank money will lead to inflation. However, there is no empirical evidence – across countries and over time – that the size of the central bank balance sheet in advanced economies is related to inflation. Even though inflation is ultimately a monetary phenomenon, the quantity of money circulating in the economy also depends on the motives underlying the demand for money by the private sector, in particular by the banking system. If the increase in central bank money helps commercial banks to finance additional private or public consumption and investment, over and above the economy’s productive potential, it may indeed fuel inflation. If, instead, the demand for central bank money reflects a change in the composition of financial market participants’ portfolios, towards less-risky assets, the increase in central bank money is not inflationary. It contributes instead to preventing deflation.

With the LTRO, the ECB has helped to reduce systemic risk and avoided a credit crunch. To minimise the inefficiencies and perverse incentives that may result from the increase in its balance sheet, and to reduce counter-party risk, the ECB should be given a greater role in co-ordinating and overseeing supervision of the eurozone banking system. The euro area needs a supervisory and regulatory compact, as much as – if not more than – a fiscal compact. Read more

When discussing Greece, some policy officials and market participants have suggested that ‘the markets are now better prepared to deal with a default’. When was the other time such statements were being made? Probably in mid-September 2008, a few days before the collapse of Lehman Brothers.

If there is one thing to learn from the past five years, it’s that financial contagion operates in unexpected ways, especially after a major shock such as the failure of a major financial institution or the default of a country. Even if markets have prepared for the possibility of a default by Greece, the practical consequences of such an event can be much greater.

Greece does not suffer from a typical balance of payment problem. It has a major structural problem that can be resolved only through a combination of macroeconomic, structural and social measures. What is required is much more similar to the kind of programme that the International Monetary Fund applies to low-income countries, under the Poverty Reduction and Growth Facility (recently renamed Extended Credit Facility), with official financing provided for several years, at concessional terms to ensure debt sustainability. Strong conditionality has to be implemented, in line with the IMF practice for this type of programme, but not under the threat of continuous default that alienates the political support in Greece for the right policies and fuels instability in financial markets. Read more

Last week’s decision by the Federal Reserve to provide a quantitative definition of price stability and the publication of the 17 Federal Open Market Committee members’ expectations of the Fed funds rate over the next few years aims at improving transparency and accountability of the central bank. It also raises several questions.

To be effective, central bank communication needs to be well understood not only by sophisticated market participants but also by the public. As they are currently designed, the new tools might turn out to be too complex, and risk creating confusion, for both groups. This could be exploited by those, in particular in Congress, who are looking for new excuses to undermine the independence of the Fed. This risk should not be underestimated. Read more

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